Franchise Disclosure Documents – Reasonableness of a Financial Performance Representation

Reasonableness of a Financial Performance Representation

The amended Rule prohibits franchise sellers from making any financial performance representation unless they have a reasonable basis for the representation at the time the representation is made. Written factual information in the seller’s possession must reasonably support the representation, as it is likely to be understood by a reasonable prospective franchisee. This factual information must be the sort of information upon which a prudent businessperson would rely in making an investment decision. Obviously, the quality and quantity of information constituting a reasonable basis may vary from case to case. The type of information needed to support and substantiate a financial performance representation will also vary, depending on whether the representation is a projection or a historic report of actual performance.

Financial Performance Representations Based on Projections

With respect to projections of potential performance, franchise sellers should consult with the current standards for projections issued by professional organizations such as the American Institute of Certified Public Accountants, e.g., Prospective Financial Information: AICPA Audit and Accounting Guide (2006). As a general matter, the following should be considered when making reasonable forecasts:

  • Financial forecasts should be prepared in good faith;
  • Financial forecasts should be prepared with appropriate care by qualified personnel;
  • Financial forecasts should be prepared using appropriate accounting principles;
  • The process used to develop financial forecasts should provide for seeking out the best information that is reasonably available at the time;
  • The information used in preparing financial forecasts should be consistent with the plans of the entity;
  • Key factors should be identified as a basis for the assumptions;
  • Assumptions used in preparing financial forecasts should be appropriate;
  • The process used to develop financial forecasts should provide the means to determine the relative effect of variations in the major underlying assumptions;
  • The process used to develop financial forecasts should provide adequate documentation of both the financial forecasts and the process used to develop them;
  • The process used to develop financial forecasts should include, where appropriate, the regular comparison of the financial forecasts with attained results; and
  • The process used to prepare financial forecasts should include adequate review and approval by the responsible party at the appropriate levels of authority.

This is not to suggest that these points constitute the complete test for whether there exists a reasonable basis for a performance projection. Nonetheless, in the view of Commission staff, projections made in accordance with the standards issued by the AICPA (or its successor) presumptively have a reasonable basis.

Financial Performance Representations Based on Historic Performance

The data underlying a historic performance representation must be subject to independent examination and verification. The data must reasonably support the representation as it is likely to be understood by a reasonable prospective franchisee. For example, a representation that franchisees earn a net profit of $30,000 per year implies that this figure is representative of the typical experience of the system’s franchisees. The representation would not have a reasonable basis if, in fact, only a small minority of the franchisees earn this amount, if profits were due to unusual or non-recurring conditions, or if the franchisees used inconsistent methods for determining and reporting their profits.

Substantiation of Financial Performance Representations

A franchise seller must possess, in writing, the supporting data underlying any financial performance representations at the time it makes the representation. Supporting data can include, for example, market studies, statistical analyses, franchisee profit and loss statements, as well as other types of information that customarily are relied upon by prudent persons in making business decisions. The written material can be in electronic or any other form that is capable of being reviewed. Impressionistic or anecdotal information such as, for example, a rough counting of a show of hands by franchisees attending the franchisor’s convention, does not meet the standard necessary to substantiate a financial performance representation.

Data from company-owned outlets may provide a reasonable factual basis for financial performance representations if the representation is properly prepared. When such data is used, a franchise seller must clearly disclose that the representation is based on the performance of company-owned outlets, and the representation must take into account for differences between company-owned and franchised outlets, imputing, where appropriate, differences in costs (e.g., royalty payments) and economies of scale. If a financial performance representation is based upon both types of outlets – franchise and company-owned – the data for each type ordinarily should be separated to avoid potential misrepresentations.

Inclusion of Financial Performance Information in Item 19

All financial performance representations must appear in Item 19 of the disclosure document. It is a violation of the amended Rule for a franchise seller to make a financial performance representation not made in Item 19 that is inconsistent with what appears in Item 19. Thus, a franchisor cannot provide or authorize others to provide prospective franchisees with financial performance information while at the same time stating in Item 19 that the franchisor does not authorize the making of any financial performance representations. Similarly, a franchise broker or other third-party cannot make a financial performance representation unless one already appears in the franchisor’s Item 19 disclosures. Franchise sellers make financial performance representations that do not appear in Item 19 at their own risk because they not only face liability for violating the amended Rule’s requirement that such representations appear in Item 19 and its prohibition against inconsistent statements, but also liability under Section 5 of the FTC Act, if such claims are false or deceptive.

Availability of Written Substantiation for Financial Performance Representations

Finally, upon reasonable request, franchise sellers must make available to prospective franchisees – and, upon request, to the FTC – the written substantiation for any financial performance representation made in Item 19. The failure to do so constitutes an independent violation of the amended Rule.

CREDITS: This is an excerpt from A Guide to Starting a Business in Minnesota, provided by the Minnesota Department of Employment and Economic Development, Small Business Assistance Office, Twenty-eighth Edition, January 2010, written by Charles A. Schaffer, Madeline Harris, and Mark Simmer. Copies are available without charge from the Minnesota Department of Employment and Economic Development, Small Business Assistance Office.

This article is also part of a series of articles on starting a franchise in Minnesota.

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